Japan's Deflation: A Hard Lesson Heeded

July 29, 2002

By Michael Wallace The June publication of the Federal Reserve's discussion paper, Preventing Deflation: Lessons from Japan's Experience in the 1990s, triggered a stampede of private-sector research imitators in July. The topic became all the more fashionable as U.S. equities continue to trace out with alarming similarity the final days of the Japanese bubble correction. While the comparison may be apt, the U.S. has sufficient advantages to ensure that it recovers from its bubble experience more rapidly.

The recent Fed paper delicately assesses the buildup of the equity, real estate, and capital-spending bubbles in Japan in the late '80s. It concludes (with the benefit of hindsight) that the Bank of Japan should have cut interest rates in 1995 by an additional 2 percentage points to prevent deflation, which did not fully develop until the late '90s. However, it concedes that even private-sector and Fed economists didn't come close to predicting deflation in Japan, which was ultimately exaggerated by the increase in the consumption tax and the Asian financial crisis.

The research concludes that, given the pitfalls in forecasting deflation, "when inflation and interest rates have fallen close to zero, and the risk of deflation is high, [monetary and fiscal] stimulus should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity." It can always be taken back with little risk in the future.

PILLARS OF GROWTH. It appears the Fed has already heeded the painful lessons of Japan by slashing base rates nearly 5 percentage points in a year. That unprecedented policy response likely had the Japan experience to thank and was surely hotly debated by members of the Federal Open Market Committee, the Fed's policymaking arm, well before the topic was thoroughly researched and crafted by staffers.

Indeed, the stimulative policy mix, more adaptable labor and financial markets, and the lower dollar will help prevent deflation and support growth in the U.S. Most important, the grateful Fed has taken a page out of the Bank of Japan's book and acted decisively. With some patience and luck, the U.S. can turn a corner as the bubble runs its course.

Unquestionably, the parallels are eerie. Japan's bubble was preceded by productivity gains, overspending on capital goods, a frothy real estate market, exuberant equity investing, and overeager lending. Even the Arthur Andersen debacle had familiar hallmarks of Japan's cozy keiretsu corporate system that encouraged imprudent lending. The U.S. bubble was exaggerated by tech spending in anticipation of Y2K computer problems and the dot.com explosion, which prompted a boom and bust in capital spending and stock prices.

SIMILARITIES -- AND DIFFERENCES. After the '80s boom, the Nikkei-225 index peaked at nearly 39,000 before falling to a trough of 9,382 in 2001, a 75% loss. So far, when calibrated against their worst levels, the tech-laden Nasdaq lost 76%, the Standard & Poor's 500-stock index shed 50%, and the Dow sank 37%. The yen appreciated sharply through the first half of the '90s, and the dollar rallied significantly in the latter half before topping out. The Bank of Japan cut rates more than 8 percentage points from 1991 to 0% by the end of the decade. The Fed slashed rates 4.75% in 2001, to 1.75%.

Contrasts are significant, though less numerous. Despite obvious regional pockets of severe home-price inflation, U.S. residential supply and demand is overall more balanced. The same is true for the commercial market. Mortgage rates will remain low. U.S. banks are better capitalized than in the past. And low borrowing costs and banking basics will buffer balance sheets from investment-banking shrinkage.

Accounting and financial reforms also will spring more quickly from the ashes of recent disclosures than was the case in Japan. Critically, labor-market flexibility, expansive fiscal policy, and previous tax cuts all bode well for a relatively more benign fallout from the U.S. bubble. Wallace is a senior market strategist for Standard & Poor's/MMS International